Sunday, May 27, 2012

German taxpayers face re-denomination loss from TARGET2

As the risks of Greek exit from the EMU increased, the mainstream financial media began to pay attention to growing TARGET2 issues within the Eurosystem. A recent Bloomberg article did a good job in describing the situation. But strangely, rather than referring to it as TARGET2 - the technical term, they called it the German "bailout" (although they've written about the topic before).

Bloomberg: - Here’s how it worked. When German banks pulled money out of Greece, the other national central banks of the euro area collectively offset the outflow with loans to the Greek central bank. These loans appeared on the balance sheet of the Bundesbank, Germany’s central bank, as claims on the rest of the euro area. This mechanism, designed to keep the currency area’s accounts in balance, made it easier for the German banks to exit their positions.

Now for the tricky part: As opposed to the claims of the private banks, the Bundesbank’s claims were only partly the responsibility of Germany. If Greece reneged on its debt, the losses would be shared among all euro-area countries, according to their shareholding in the ECB. Germany’s stake would be about 28 percent.

Let's help Bloomberg with the explanation here. To start with, this is the "tricky part" - it's actually fairly straightforward. The arrows point to the direction of claims.

And here is how the Bundesbank claims grew. Bundesbank refers to it as "BBK01.EU8148: External position of the Bundesbank since the beginning of EMU / Claims within the Eurosystem / Other claims (net)". For those who have trouble finding it on the newly redesigned Bundesbank website, you can plot it using Bloomberg charts here (just extend the period to 5 years to see the full effect).

Bundesbank "other claims" on the Eurosystem

But Bloomberg has yet to take that extra step and describe what would actually happen with these claims should a periphery nation exit. The exit would simply result in a re-denomination of some claims and would look like this:

There is no other way to do this. As loans to Greek banks become drachma denominated, so will the claim on the Bank of Greece (BoG), with the central bank separating from the Eurosystem. The Eurosystem was never designed for an exit of a central bank, so this process would need to be cobbled together on the fly - sort of the way the Greek restructuring was done. The "exercise" may potentially set up a process for other nations exiting the EMU.

In this scenario the Eurosystem's asset (claim on the BoG) is denominated in drachma and the liability in euros. The resulting P&L from the drachma devaluation will hit the books of the ECB and will need to be shared by the remaining Eurozone partners (of which Germany is 28%). So as the Bloomberg article points out, even if Germany avoided a massive direct bailout of Greece and other periphery nations, this "backdoor bailout" exposure will sill end up on the doorstep of German (and other core nations') taxpayers.

Bloomberg: - In short, over the last couple of years, much of the risk sitting on German banks’ balance sheets shifted to the taxpayers of the entire currency union.

It’s hard to quantify exactly how much Germany has benefited from its European bailout. One indicator would be the amount German banks pulled out of other euro-area countries since the crisis began. According to the BIS, they yanked $353 billion from December 2009 to the end of 2011 (the latest data available). Another would be the increase in the Bundesbank’s claims on other euro-area central banks. That amounts to 466 billion euros ($590 billion) from December 2009 through April 2012, though it would also reflect non-German depositors moving their money into German banks.

By comparison, Greece has received a total of about 340 billion euros in official loans to recapitalize its banks, replace fleeing capital, restructure its debts and help its government make ends meet. Only about 15 billion euros of that has come directly from Germany. The rest is all from the ECB, the EU and the International Monetary Fund.